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Capturing Value and Avoiding Commoditization: Business Model Differentiation & Pricing (videos+article)

If the role of marketing was ever to bring about a balanced relationship between sellers and buyers, then why in many industrial sectors it has failed to live up to that promise.

When the benefits and values are not perceived by the customer and the attributes are standardized, goods and services become commoditized.

According to Professor Michel, “Commoditization is a bad word. It is procurement’s weapon to make you lower your prices.

And this makes Professor Kamran Kashani wonders:
If the role of marketing was ever to bring about a balanced relationship between sellers and buyers, then why in many industrial sectors it has failed to live up to that promise.
 
Consider the following scenario.

Your core product or service has lost its uniqueness: competition has copied your winning features and is underselling you by a wide margin. Your customers, once delighted with your innovations and quality services, are now only interested in your price.

They view all competing offers alike and dismiss your claims to the contrary as just a hollow sales pitch, and a handful of large customers, who account for an increasing share of your turnover, are aggressively using their bargaining power to the detriment of your prices and margins.

And, as if that wasn’t enough, your marketing has become powerless as no amount of persuasive communication and brand building can redress this imbalance of the bargaining positions.

If you’re facing a scenario best described as “commoditization hell”, a situation faced by many companies who have seen their control over prices disappear along with their brand equity and customer loyalty.

 

Can you fight commoditization and win?

The answer for a growing number of companies is an affirmative one. Their managements have discovered profitable opportunities in redefining their core business and are offering their customers compellingly differentiated values – values that they are willing to pay a premium price for. These companies have thus found ways of countering commoditization.

The following examples illustrate how two companies have done just that.

  • SKF, the world’s largest ball bearing manufacturer, has turned its extensive know-how in rotation technology into value-added services for manufacturing operations.

Far from haggling over the price of commodity bearings, the company now helps its productivity conscious customers, such as pulp and paper manufacturers, to maintain their production machinery, reduce or eliminate downtime, and maximize plant yield. Many of these services come with performance guarantees that are offered on the basis of contracts that ensure continuity of supply and expert advice for plant operators, and long-term account retention for SKF. The company’s service business is today its fastest growing and most profitable division.

  • BASF, one of the world’s largest producers of industrial paints, has stretched out of its increasingly commoditized products into coatings for specialized applications, in addition to integrated coating systems and solutions.

With the Integrated Paint Shop, an innovation in auto coating business, BASF offers to apply its vast know-how in paints to operate a car manufacturer’s paint shop, providing all coating products specified by the customer (including those produced by competitors) in addition to technical advice and logistical support. Under this concept, offered to an increasing number of car makers including DaimlerChrysler, Volkswagen and Ford, BASF is paid not by the volume of coatings used – the common practice in the industry – but rather by the number of painted car bodies that pass the quality checks. The Integrated Paint Shop innovation has been a highly profitable addition to BASF revenues.

The markets for bearings and coatings in which SKF and BASF compete are commoditized, and buyers have the last word. Unlike many of their rivals, both companies have chosen to refrain from becoming cut-price vendors, a strategy that would probably have won them a few additional market share points, but with significant erosion in their profitability.

Instead, they have chosen to fight commoditization by becoming knowledgeable about the businesses of their major customers, and by using that knowledge to bring value-added products and services to their markets.

The cases of SKF and BASF illustrate how a firm can bolster its customer value proposition to combat commoditization.

 

Value-Added Strategies

When all customers appear to look alike, and the firm’s value offer has a one-size-fits-all quality to it (both features of many commoditized markets), it is time to ask some fundamental questions: beyond the lowest price, what else do customers really value, and how could the present commoditized offer, products or services, beredefined to better respond to their often unarticulated needs?

BASF learned that the main concern for its increasingly cost conscious auto paint customers was not the per kilo price of the paint, but the total cost of a painted body. So instead of haggling over the paint price, the company put its energies into finding ways of reducing the customer’s total cost of coatings, in which the paint accounted for just a fraction.

Such discoveries are the initial insights for redefining a vendor’s offer for more value to the customer, and greater differentiation and pricing discretion for the supplier – a true win-win outcome.

So what are the strategies that create added customer value and, in doing so, fight commoditization?

To begin with, there are no quick fixes to the pervasive power of commoditization. As a permanent feature of today’s marketplace, it will continue to challenge business organizations, even the best managed.

While there is no panacea, we can still identify at least three possible strategic trajectories, which could bring much needed differentiation to a commoditized core business.

These generic strategies are highlighted in the “Value Space” matrix shown below.

 

Value Added Strategies

 

Let us first start with the two dimensions of the matrix: Segmentation and Customization, and Bundling.
They reflect the ways a company could add value to a non-differentiated core product or service.
By moving to the right along the horizontal axis, the firm is increasingly segmenting its current and potential customers and, in doing so, customizing its offers around the particular, and often unmet, needs of those segments.
Along this axis, therefore, added value is created by more effectively meeting the requirements of the different customer segments or individual accounts.
By moving up the vertical axis of the matrix, on the other hand, the firm is augmenting its value proposition, beyond its core product, by “bundling” related or even unrelated products and services into a single offer. In other words, there is more to the offer than the commoditized core product, thereby allowing greater differentiation.

The extra customer value that comes with bundling can be measured in the greater speed and convenience of working with a single supplier, a lower transaction cost, and a more complete quality assurance for the augmented offer.

The two value-adding dimensions described above lead to four possible combinations, identified in the matrix as Core, Targeted Extension, System Development, and Solution Innovation.
The latter three pertain to value-adding strategies. To understand the significance of each of the four quadrants, they are further elaborated below.

  • Core: This quadrant, low on both value-adding dimensions, is the starting point, where a company’s offer lacks sufficient differentiation to avoid the commoditization trap. Customers do not perceive compelling differences between the firm and its rivals. What is offered is not sufficiently adapted to the specific requirements of individual customers or their segments, nor does it have an added “bundled” value. Nevertheless, the firm may still attempt to bring a measure of vitality to its commoditized business through a combination of operational excellence (including incremental quality enhancement), and continuous improvement.

A good example of revitalizing a commoditized core is that of Dow Corning. Recognizing that its mature silicone products could no longer be coupled with the company’s excellent service and sold for premium prices, Dow Corning created a separate business and a new brand, Xiameter, for selling through the web its commodity range of products to volume customers at highly competitive prices. The success of the ‘no-frills’ Xiameter illustrates how companies might de-bundle products from services, and reformulate their stripped down value proposition to profit from commodities.

  • Targeted Extension: This quadrant represents a strategy that aims to add value by stretching the firm’s core offer into more segments, to better meet special needs. Under this strategy the firm may decide to pursue the dual tactics of offering the under-adapted core product to some customers, and the more targeted ones to others.

Alveo, a European producer of polyolefin foams, has used this strategy to extend into diverse applications (such as wooden floor underlay, lining for shoes, cap seals for cosmetic bottles, and others) by customizing a standard foam product to the specific requirements of each segment. The extra adaptation has meant greater flexibility in pricing, with some of the more advanced applications carrying a price premium of 35% over the undifferentiated core product.

  • System Development: Firms choosing to compete in this quadrant develop a package of products and services that offer the synergistic benefits of a “system”. The value added for the customer lies in the integration of the system’s constituent elements, so that the “bundled” whole is larger than the sum of its parts.

SKF, for example, sells car and truck repair and replacement kits incorporating its core product, ball bearings, encased inside a sub-assembly such as a water pump, a clutch release unit, or a belt tensioner. In addition, the kits include accessories such as seals, nuts, and other tools for safe and rapid installation. Not all the bundled components are produced by SKF, many are outsourced. But the finished kit carries the company’s brand and performance guarantees.

  • Solution Innovation: What happens when a firm’s offer consists of a full set of bundled products and services that are specifically targeted at certain customer segments or individual accounts?

This is precisely the strategic scenario of the upper-right quadrant where value creation takes an ambitious turn away from the core business, and addresses specific customer problems with specific solutions – solutions that combine tangible products with highly focused intangible services such as technical advice, training, consulting, and the like.

BASF’s Integrated Paint Shop package of products and services is an example of a solution innovation in the auto coating industry. Each package is constructed around the very specific requirements of a car company and a plant; it represents a one-stop sourcing of products and services, with significant savings for the customer.

A firm planning to enter the solutions business needs to “think outside of the box” and reinvent what the industry has traditionally defined as value.

Solutions strategy demands innovation in value creation.

And it promises attractive margins.

Stretching Beyond the Core

GE’s Healthcare division, one of the world’s largest makers of medical imaging products, is an example of a company employing multiple value adding strategies, as its core technologies products such as magnetic resonance imaging and tomography scanners are maturing.

GE Healthcare has been active in finding new sources of differentiation and revenues along each of the three value added trajectories defined above.

As shown below, imaging products have been extended towards increasingly narrow medical applications including cardiovascular, neurological, orthopedic, and vascular. Each focused extension consists of products and application programs targeting the specialists in the medical area. The company has also bundled its product offerings with a wide array of services in the areas of financing, information technology, technical service and training.

GE Healthcare: Reaching Beyond the Core

 

More recently, with the launch of Performance Solutions, a package of tailored services, GE Healthcare has entered the potentially lucrative consulting business targeting public hospitals and private clinics.
The new offering provides a full range of services aimed at upgrading the productivity and operational efficiency of investments made in medical equipment.
Expanding capacity and patient throughput, increasing revenue growth, and improving the return on invested capital all make up the customer value proposition of GE Healthcare’s solutions business.

Marketing Customer Success

If there is a single common denominator for all value-adding strategies described here, strategies that have a fighting chance to counter commoditization, that denominator is customer success.

The added value and the differentiating power of each strategy lie in its attempt to reach beyond a traditional definition of the core product or service, so as to offer customers novel benefits that boost their success in their own business.

Benefits include increased productivity, reduced cost, and general improvement in competitiveness.

The job of marketers in such demanding context must be multifaceted: understand key drivers of a customer’s business success, discover opportunities for new customer benefits, formulate strategies that deliver those added benefits, and then ensure effective strategy implementation throughout the organization.

But short of customer success as a guiding light for strategy and management action, any attempt to differentiate a firm’s products or services will be rightly viewed by the market as nothing more than marketing hype.

And that’s no way to fight commoditization.

 

Capturing Value and Avoiding Commoditization through Pricing Excellence

According to Professor Stefan Michel , while organizations might think they understand competitive pricing, potential sales are often lost because of price competition.
The challenge that most businesses face is that they cannot afford to adopt a lowest price strategy.

To compete successfully in today’s business environment, companies need to achieve pricing excellence.

Google is the world champion of pricing excellence. It is able to ascertain from its customers how much they are willing to pay and adjusts its pricing to reflect this. This is the essence of the pricing excellence model.
The ultimate goal is to uncover and capture the value that is created for each customer.

 

In order to develop a pricing excellence culture, it is crucial to understand these four capabilities:

  1. Customer data and insights: Understanding  what  customers  really want and how much they are willing to pay for what they want
  2. Economics: Understanding both the internal economics of the company and the economics of the market
  3. Pricing  management:  Setting  the right price and making sure that your discounting policy makes sense
  4. Pricing psychology: Understanding that it is the customer’s perception of the price that drives the behavior.

 

One company that clearly knows how  to use customer insights to its advantage is Bossard, a Swiss-based fastening technology company that sells screws, nuts and bolts to companies such as Tesla.

Having discovered that its  customers’ employees were spending more time manually lubricating screws than putting machines together,  Bossard  teamed  up with a chemical company to find a way of producing fasteners with a lubricant already applied, thereby capturing significant value for its customers compared with the next- best alternative.

Although the lubricated screws are more expensive, the time- and cost-saving is such that customers are willing to pay the higher price.

With an operating margin that is about twice the industry average, Bossard has clearly leveraged its customer insights.

Customer data and insights

In order to capture more value, companies need to understand what their customers really want  and  their willingness  to pay for it.

One way customers reveal their willingness to  pay  is through  self- segmenting, i.e. they themselves choose the high- or the low-price offer.

A good example is grocery coupons, which offer discounts on specific  items for a certain period of time. Coupons are an excellent way for retailers to generate more traffic and sell inventory but more importantly, they allow customers  to segment  themselves through  their  willingness  to  pay. Often shoppers cannot be bothered to search for and redeem coupons, thereby effectively choosing to pay the full price.

Most companies do not succeed in generating good customer data and insights  because  greater emphasis  is put  on  product  attributes rather than on benefits. While  attributes  are  easier to focus on because they are  tangible and measurable, customers do not buy attributes – they want the benefits.

The fundamental insight is going from focusing on attributes to benefits.

When identifying benefits, companies should look at ways to relieve (what does the customer hate doing?) and to enable (what does the benefit enable the customer to do?).

Pricing economics

According to economists, markets are governed by the law of supply and demand. If a company prices its product high, it will sell less. If a company’s prices are low, it will sell more. These are the basics of the supply and demand curve. Companies never know what their demand curve is going to look like.

From a pricing excellence viewpoint, the challenge is that the demand curve does not capture customers’ willingness to pay more.

Although customers may be willing to pay a premium over the market price, companies lose this value if they give a standard list price to all their customers.

They would need to have several prices in the market at the same time representing differences in value.

The problem with this method is that customers will observe the multiple prices and choose price over value.

To overcome  this,  companies  need  to  put a smart fence between customers who appreciate value and those who are just looking for a low price.

This is one of the most important strategies in pricing excellence – customers who are willing to pay for value should not be offered a low price.

 

Pricing management

One way to achieve pricing excellence through pricing  management  is  to reduce harmful discounts.

According to Professor Michel, there are only two types of discounts: “stupid” ones and smart ones.

By eliminating the “stupid” ones, companies can increase their  margin by an average of 1%.

The problem is that in many cases, the harmful discounts have become part of the organizational culture making it diffi to identify and eliminate them.

If you offer a discount, you need to make it more difficult  for customer.

Airline tickets are a good example. While most airlines offer discounts, these usually come at a price, for example requiring the consumer to fly during off-peak hours or only being available on certain days of the week.

Flights are offered at incredibly low prices to begin with but gradually increase in price as time goes on.

Since passengers are often not able to book flights  months in advance, they are forced to pay the full price for last- minute bookings, luggage, etc.

 

Pricing psychology 

There is a tendency to believe that it is the price that drives consumer behavior, but it is in fact the customer’s perception of the price that drives their behavior.

Therefore, pricing management is also perception management; it is important to know how people perceive price.

A good illustration of this is a customer showing interest in a car at a showroom.

Which model should the salesperson show first – the high-end model or the low-end model?

Research shows that customers tend to buy products that are more expensive if they are shown the high-end model first. If they see the low- end model first, they tend to perceive an increase in cost when they are shown the high-end model.

Conversely, when they are presented with the more expensive model first, they feel that they are losing value when they see the cheaper model. This is referred to as loss aversion – a tendency for people to avoid losses over gains.

Another aspect of pricing psychology is the “price carrier” i.e. what you put the price tag on.

This is important because it is not always possible to put the price on the value you are creating for the customer.

Nespresso, changed the price carrier from a kilo of coffee to a cup of coffee. Nespresso aficionados, for example, are happy to pay €0.60 for a capsule, i.e. an incredible €140 per kilo of coffee.

The price carrier decision is a fundamental part of pricing excellence.

Frequent dilemmas in pricing excellence

In many companies,  the  full  potential of value-based pricing is not exploited because different stakeholders have competing objectives, inevitably  leading to pricing dilemmas.

Participants identified some of the dilemmas they have experienced in their own organizations:

  • Short  term  vs.  long-term  customer management
  • Discount vs. cash flow
  • Price consistency vs. make the sale
  • Profit per SKU vs. profit per customer
  • Internal vs. external forces
  • Profit vs. mission
  • Everyday low prices vs. promotions.

Companies faced with these types of dilemmas need to focus once again on the customers’ willingness to pay rather than the organization’s preferences and culture.

One way to resolve these dilemmas and understand what customers value is to run experiments by forcing each other to make assumptions about customers and then to check if the assumptions are right.

Although organitions can become smarter about pricing, there is no perfect solution. It is a problem that needs to be addressed in most companies. Otherwise, pricing becomes a power game and not about optimizing customer value.

 

Adobe Creative Cloud Is Our Future

In May 2013, David Wadhwani, Adobe’s senior VP and general manager for digital media, announced that the Adobe Creative Suite 6 (CS6) would be the last release of Adobe’s creative products to be offered with perpetual licensing.

CS6 is a powerful software package for graphic designers, webmasters and creative professionals that includes Photoshop, Illustrator, Premiere, InDesign, Lightroom and many more applications for creative work.

Instead, all future development efforts would go into Adobe’s Creative Cloud, where the applications would no longer belong to the user; instead, they would be provided by Adobe for a monthly subscription fee.

 

Creating pricing excellence with new business models: Adobe Creative Cloud case study

The advantages and disadvantages for Adobe of the switch from the standard software package to a monthly subscription fee on the cloud:

Advantages 

  • Consistent revenue stream
  • Customer insight – (Adobe knows what customers use)
  • Lower structural costs (Adobe saves on the physical item and retail costs)
  • Illegal copies no longer possible
  • Better segmentation
  • Speed of innovation
  • Customer retention
  • Barriers to entry (of competitors – all assets are on the cloud).

Disadvantages 

  • Big financial hit initially (revenue and profit decline)
  • Declining share price
  • Setting the right price
  • Forced connectivity
  • Internal resistance
  • Can’t charge for innovation
  • Loss of customers
  • Unhappy customers.

 

With its new business model, Adobe’s focus was on customer retention. The company had instant access to big data on its customers, enabling it not only to ascertain the features and services they were using but also to study which user actions led to customer conversion and retention – “high value actions” (HVA).

Setting the right price was a concern – the team had to estimate how many existing customers would remain, how many new customers could be gained, how long they would stay  and how often they would upgrade.

Adobe’s Creative Cloud was launched in June 2013 for $49.99 per month with full access to all applications and 20 GB of cloud storage. Product adoption exceeded Adobe’s expectations; indeed customer satisfaction was significantly higher.

Value was created for both the customer and for Adobe.

 

Capture more value

There is no easy answer or quick fix for achieving pricing excellence.

However, in order to successfully manage pricing excellence, it is necessary to understand the core capabilities that influence organizational pricing.

The most important thing to remember is in order to create more value, a company needs to capture this value in its pricing strategy.

Otherwise, the company will always lose customers to low-cost competitors.

 


 

Obstacles to Implementing Value-based Pricing

According to Professor Stefan Michel, research supports the finding that value-based pricing leads to higher profits than cost-based, or competition-based  pricing.
Yet, despite this, cost, or competition-based pricing is used extensively.
(See Table 1 for a comparison of the three types of pricing and Table for the sequence of pricing considerations.)

Table 1: Comparison of three most important pricing principles

Cost-basedPricing

Competition-basedPricing

Value-basedPricing

Description

Based primarily on data from cost calculations

Based primarily on information about competitors’ prices and products or services offered

Based primarily on information about the value that the customer attaches or can be induced to attach to offerings

Examples for concrete action

Cost plus pricing: Calculating the cost and determining a markup for profit

Research competitors’ prices (using specific competitors or average prices), followed by determining

a target price difference (e.g. comparisons of products or services offered)

Determining the added value of a product or service for the customer, or an empirical determination of what a customer is willing to pay for a given product and then identifying the resulting contribution to profit

Strengths

Basic data relatively easy to obtain; often perceived as “fair” by the customer

Basic data relatively easy to obtain; takes into account price pressure arising from the competitive situation

Can come close to exhausting the customer’s willingness to pay while taking into account the

competitive situation and financial consequences

Weaknesses

Neglects customer needs and the competition; leads to suboptimal prices that are either too low and waste the margin or too high and discourage sales

Tends to encourage mechanical reactions to the competition’s price behavior and can lead to price wars; neglects customer needs and leads to “product-oriented” assessments of differences in products offered, which are irrelevant to needs;

in some markets, there is no information on market price or competitive prices

Difficult and usually costly to obtain basic information; implementation can involve additional costs and lead to resistance; customers may perceive certain aspects as unfair

 

Table : Sequence of pricing considerations

Pricing principle

 Starting Point

 Result

Cost-basedpricing

Offer (product, service)

Cost plus “profit markup”

Price

Product-oriented sales

Competition-based pricing

Competition (prices, offers)

 

Positioning in relation to the competition

 

 

Price

 

Greatest competitive pressure, fight for market share

Value-basedpricing

Customers (needs references)

 

Value-specific benefit attributes from customer’s perspective

 

 

Price

 

Offer oriented to needs, target costs dependent on price

 

There are various obstacles managers face when implementing VBP.

Implementation costs

  • Investment required to differentiate the benefits of different product versions
  • Risk of price erosion through arbitrage
  • Cost of market research to assess differentiated customer value
  • Cost and complexity of price setting and communication.

Implementation challenges

  • Market segmentation and determining segment-specific prices
  • Communicating differentiated customer value
  • Customer resistance due to perceived unfairness.

Pricing mistakes: For a business-to-business company with sales of US$2 billion, McKinsey estimated that the costs of correcting pricing mistakes were approximately $2 million plus $20 million in lost sales. And the cost of customer dissatisfaction is inestimable.

Implementation costs of VBP

Investment required to differentiate the benefits of different product versions

Differentiated  prices  are  often   recommended for fundamental services or core products with different key attributes.

Different product versions can help take full advantage of what customers are willing to pay, thereby increasing earnings. But it is important to note that there will come a point of diminishing returns,  where the  cost  of  additional  versions may be higher than the additional earnings they generate. Companies must consider not only production costs, but also the administrative costs of a greater product range and the associated guarantee and service costs.


 

Risk  of  price  erosion  through  arbitrage

VBP often results in a price structure where some customers pay higher prices, while others benefit from lower price. The danger is that you may unintentionally give unnecessary price reductions to customers who would be willing to pay more.

Firms must work with customers, employees and trading partners to identify and eliminate price inconsistencies.

Assessing differentiated customer value

The biggest obstacle to introducing VBP lies in assessing the differentiated customer value (i.e. the specific value that a product or service has for a customer) and the associated market research costs. Customers must have a thorough understanding of processes to assess how much added value one solution can generate compared with the next-best alternative.

Communicating differentiated customer value

After identifying price-specific segments, the company must communicate the differentiated customer value.

Value differences such as long-term cost savings or revenue enhancements are only credible if they are backed up with supporting data. A differentiation in price should be communicated in such a way that it reinforces the highest price as the reference price and ensures that lower prices are linked to conditions that seem both understandable and fair.


While VBP is superior to other pricing approaches in most situations and in respect to the goal of profit optimization, the majority of firms still use cost- based pricing as their dominant approach.

Being aware of those obstacles helps managers to assess where and when to apply VBP and which execution strategies and tactics to use for pricing excellence.